Real Estate seminar on Tax Implications of Lease Options

Did you know that lease options also have IRS and tax regulations and tax codes regarding how to do profits in a lease option transaction?  We have, for individuals, the IRS codes for those naysayers that wonder if lease option investing is a legitimate business opportunity.  It actually shows you how to do your taxes or how a CPA would report the earnings for a lease option, whether it be an upfront option money, cash flow, or whether the property has been sold within a year or down the line.  It shows you how to report those earnings and those profits.

If somebody ever tells you that lease options are illegal, show them the IRS codes.  That really shocks them because if Uncle Sam knows about it, you can be sure Uncle Sam looked into it because Uncle Sam wants to get paid and when Uncle Sam gets paid, everything is okay.  Lease options are definitely legal and a business opportunity you can make money now.

Just some of the tax questions that come up in our seminars is about mortgage deductions. You can usually still deduct your mortgage interest payments from your income taxes during the term of the lease option. In general, you also do not need to pay any tax on the option money until the lease ends. At that point, you will need to include it in your capital gain from the sale of the house or, if the sale doesn't go through, report it as rental income. 

The following from an atttorney who also invests in real estate, Bill B., ESQ. 

"There are some interesting and lucrative advantages of using options as both an optionor and optionee of real estate. Generally speaking, option money is not taxable to the optionor until the option is exercised, expires or is abandoned. I.R.C. Section 1234 (subject to "dealer" rules, discussed below). If it expires or is abandoned, it is taxable to the seller as ordinary income at the time it expires or is abandoned.

A personal residence sold under lease/option may still qualify for capital gains exemption. Under the 1997 Tax Reform Act, gains from the sale of a personal residence seller are exempt so long as the gain is less than $250,000 ($500,000 for married couple). So long as the lease was incidental to the sale, court decisions have held that the property would still qualify as a personal residence and not a rental. See, Bolaris v. Commissioner, 776 F.2d 1428 (9th Cir 1985). If the value of your property has increased substantially since you bought it then you may want to consider the tax implications of the capital gain. You can deduct up to $250k ($500k if married and filing jointly) from your federal return if you have owned and lived in the property for at least 2 of the past 5 years. Put another way, if you lease the property for 4 years and then sell it, you can not take that deduction and will have to pay capital gains on the appreciation.

The lease and option payments made by the tenant are not tax deductible if the property is used as a residence. If tenant purchases the property, his option payments (including monthly rent credits) become part of his tax basis in the property. The tenant's option payments may be deductible as a capital loss if the buyer is an investor. For example if you lease/option a home to live in, consider using your corporation to take the lease/option, then sublease to yourself individually. If you don't exercise the option from your corporation, have the corporation treat the option money it paid as a loss.

Take A Loss On Your Personal Residence

 As you may know, you cannot take a loss on your personal residence if you sell it for less than your basis. You can, however, take a capital loss on an investment property.

 Move out of your house and lease/option it to a tenant/buyer for a few years. Report it on your Federal income tax return as a rental on schedule "E." You may now be able to take a loss when the tenant exercises his option to purchase. Make certain that you make this transaction it look legitimate; the IRS is keenly aware that people in down real estate markets try to "fudge" rental agreements to accomplish a loss on their personal residences.

Watch Out For "Dealer" Classification If you are an active real estate investor, you should be aware of what the IRS calls "dealer status." If you also buy and sell real estate on a regular basis, you may be considered a "dealer" in real estate properties. A dealer is one who buys with the intent of reselling rather than for investment. There is no magic formula for determining who is an investor and who is a dealer, but the IRS will balance a number of factors, such as the purpose for which the property was purchased, how long the property was held and how many deals the investor did in relation to other income. If you take option consideration on a "dealer" property, you cannot defer taxation of option consideration under Section 1234 of the Code.

IRS Reclassification

Occasionally, but rarely, the IRS will reclassify a lease/option as a disguised sale. This is more common with equipment leases where the lessee makes rental payments for a number of years then has the option to buy at the end of the term for a nominal amount, such as $1. The IRS looks at the terms of the deal and the circumstances surrounding the deal to determine whether a sale was intended. For example, if the tenant is paying the taxes and insurance, this looks more like a sale. If a substantial part of the payments on the lease are credited towards purchase, this also looks like a sale. If the option price declines each year rather than increases with the market . . . well, you get the idea - it if looks like a duck, and it quacks like a duck, its a duck! Most of the reported cases wherein the IRS reclassified a lease/option as a sale involved long-term leases. Thus, a lease/option of only a few years with your tenant is not likely to be re-characterized as a sale."

Consult a tax professional for more details to ensure that lease options is not a scam or unproven business opportunity. The laws and customs of your jurisdiction may vary, so consult a real estate agent or attorney before entering into a lease option. This article is a general guide only and is not intended to replace professional legal or financial advice. For a copy of the IRS Tax Codes and other information visit www.GuaranteeProfits.com